The Full Convertibility of the Renminbi: Sequence and Impact

1. The Full Convertibility of the Renminbi: Sequence and Impact Drafted by Shucheng Liu and Zhijun Zhao Hong Kong Institute for Monetary Research and Economic Institute, Chinese Academy of Social Sciences Research Project Group: Yue Ma Associate Professor, Economics Department, Lingnan University Yak-yeow Kueh Chair Professor, Economics Department, Lingnan University Shu-ki Tsang Professor, Economics Department, Hong Kong Baptist University Matthew Yiu Manager, Hong Kong Institute for Monetary Research

2. This paper was written while we were visiting Research Fellows at the Hong Kong Institute for Monetary Research. We wish to thank the HKIMR for their hospitality and support. The views presented in this paper are those of the authors and do not necessarily reflect those of the HKIMR. 1. Introduction This paper discusses the sequence of the Renminbi’s full convertibility and its possible impact on mainland China’s economy and Hong Kong’s economy.

3. 1. Introduction (Continued) China’s entry into the World Trade Organization (WTO) will effectively speed up the full convertibility of the Renminbi. Foreign banks will be allowed to make corporate loans in local currency within two years of entry Foreign banks will be allowed to deal with individual Chinese customers within five years after entry. Some people thus point out that these measures mean the Renminbi will soon become a fully convertible currency. We think this viewpoint is incorrect.

4. 1. Introduction (Continued) It is because this viewpoint confuses the capital account convertibility with the Renminbi’s full convertibility. It also confuses removing restrictions on transactions with removing restrictions on exchange. The measures mentioned above are just important steps towards removing restrictions on capital account transactions. They are not yet equivalent to capital account convertibility and still far from the Renminbi’s full convertibility.

5. 1. Introduction (Continued) The paper is organized as follows. Section Two focuses on the sequence of the Renminbi’s full convertibility. Section Three develops a general equilibrium model for an open economy. Section Four analyses the possible effects of the Renminbi’s full convertibility on mainland China’s economy and Hong Kong’s economy. Section Five provides the conclusions.

6. 2. Sequence of the Renminbi’s Full ConvertibilityA. A review of the experience of developed industrial countriesB. Three stages in the Renminbi’s full convertibility After World War Ⅱ, developed industrial countries stepped towards the capital account convertibility in a relatively cautious way. (See Table 1 and Table 2)

7. Table 1 Currency’s Convertibility in Developed Industrial Countries(In Order of the Time When Establishing Capital Account Convertibility)

8. Table 2 Currency’s Convertibility in Developed Industrial Countries(In Order of the Interval Time between Current Account Convertibility and Capital Account Convertibility)

9. B. Three Stages in the Renminbi’s Full Convertibility There does not exist a uniform or fixed sequence of the currency’s full convertibility due to the differences across countries. At the same time, based on the common practice and basic sequence taken by most countries in the world, drawing on the experience and lessons from other countries’ practice and in view of the fact that China is a large developing country, we believe that a steady and carefully designed sequence is needed.

10. B. Three Stages in the Renminbi’s Full Convertibility(continued) The whole course of the Renminbi’s full convertibility, we think, should be broken down into three major stages in general. Stage One, Adopting current account liberalization. (It was established by 1996.) Stage Two, Adopting capital account liberalization. (It’s currently going on.) Stage Three, Adopting the Renminbi’s full convertibility. (It will take place in the future.) As to the stage of current account liberalization and the stage of capital account liberalization, each should be further broken down into two successive steps. Step One, Removing restrictions on current account or capital account transactions. Step Two, Removing restrictions on current account or capital account exchange, namely adopting current account or capital account convertibility. (See Table 3)

11. Table 3 Sequence of the Renminbi’s full convertibility

12. Stage One Current account liberalizationStep One Removing restrictions on transactions Removing current account restrictions on transactions means removing restrictions on current international transactions themselves and still retaining current account restrictions on exchange, i.e. retaining the examination and approval system relating to current account exchange.

13. Stage One Current account liberalizationStep Two Removing restrictions on exchange On the basis of having removed some or most of current account restrictions on transactions, a country can further remove current account restrictions on exchange, namely adopting current account convertibility. It means removing the examination and approval system relating to current account exchange and only retaining audit on the authenticity of transactions. According to Article 8, Section 2(a) of the IMF’s Articles of Agreement，current account convertibility means that no member shall, without the approval of the Fund, impose restrictions on the making ofpayments and transfers for current international transactions.

14. Stage Two Capital account liberalizationStep One Removing restrictions on transactions Removing capital account restrictions on transactions means removing restrictions on capital international transactions themselves and still retaining capital account restrictions on exchange, namely retaining the examination and approval system relating to capital account exchange. China has been generally on the process of removing capital account restrictions on transactions. In 1979, it began to reform and open to the outside world. In 1996, it established current account liberalization.

18. Stage Two Capital account liberalizationStep One Removing restrictions on transactions(continued) Note that the measures mentioned above are just important steps towards removing restrictions on capital account transactions. They are not yet equivalent to capital account convertibility and still far from the Renminbi’s full convertibility. For instance, by that time, resident individuals may be able to deposit Renminbi in foreign banks residing in China, but what they can draw from the banks is still Renminbi and not foreign currency. If resident individuals want to draw out foreign currency to pay for capital international transactions, they still need, in accordance with the China’s relevant regulations, to go through the procedures relating to exchange.

19. Stage Two Capital account liberalizationStep Two Removing restrictions on exchange On the basis of having removed some or most of capital account restrictions on transactions, a country can further remove capital account restrictions on exchange, namely adopting capital account convertibility. It means removing the examination and approval system relating to capital account exchange and only retaining audit on the authenticity of transactions. Until now, there still exist strict capital account exchange restrictions that need to be lifted up step by step in due course.

20. Stage Two Capital account liberalizationStep Two Removing restrictions on exchange(continued) (1) Direct investment Regarding foreign direct investment, some exchange restrictions have been lifted up already. The remaining restrictions are the prohibitions against the remittance of foreign exchanges into China as an investment by overseas legal persons or natural persons. These foreign exchanges could only be settled with the approval of the State Administration of Foreign Exchange (Regulations on the Administration of Settlement, Sales and Payment of Foreign Exchange).

21. Stage Two Capital account liberalizationStep Two Removing restrictions on exchange(continued) (1) Direct investment Concerning China’s direct investment abroad, current exchange restrictions are also very strict. Under the existing rules, when making an investment abroad, institutions residing in China shall receive an audit on the source of their exchange capital by foreign exchange administrative agency. (Rules on Foreign Exchange Administration of the People’s Republic of China)

22. Stage Two Capital account liberalizationStep Two Removing restrictions on exchange(continued) (2) Portfolio investment With regard to issuing securities to foreigners and opening domestic securities market, exchange restrictions are still very strict. Under the existing rules, foreign exchange received from issuing foreign currency stocks and bonds could not be settled without the approval of State Administration of Foreign Exchange (Regulations on the Administration of Settlement, Sales and Payment of Foreign Exchange).

23. Stage Two Capital account liberalizationStep Two Removing restrictions on exchange(continued) (2) Portfolio investment With respect to purchasing foreign securities, exchange restrictions are also very strict. Under the existing rules, institutions and individuals residing in China are forbidden to buy foreign exchange for the purpose of purchasing foreign currency stocks issued abroad. (Circular on Relevant Issues Regarding Perfecting Foreign Exchange Administration Relating to Capital Account.) (Provisional Measures on Foreign Exchange Administration Relating to Individuals Residing in China.)

24. Stage Two Capital account liberalizationStep Two Removing restrictions on exchange(continued) (3) Loans For loans, restrictions on exchange are also extremely strict currently. Under the existing rules, without the approval of State Administration of Foreign Exchange, institutions residing in China could not deposit abroad the raised international commercial loans, use them for overseas direct payment or convert them into Renminbi(Measures on the Administration of Raising International Commercial Loans by Institutions Residing in China).

25. Stage Two Capital account liberalizationStep Two Removing restrictions on exchange(continued) We can see from the above analysis that on the whole, there is still a lot to do in the removal of various restrictions on capital account transactions and exchange. The removal of restrictions cannot be accomplished in a single action.

26. Stage Three The Renminbi’s full convertibility The Renminbi’s full convertibility means removing in all respects exchange controls relating to the Renminbi, removing audit on the authenticity of current account and capital account transactions and allowing the Renminbi’s convertibility without the occurrence of any real transactions. This clearly could not be established within five years after China’s entry into WTO.

27. 3. A General Equilibrium Model for an Open Economy Adopting the Renminbi’s full convertibility will involve a very broad range of areas, including macro-economy and micro-economy, real economic activity and financial activities, internal and external economic balances, price, interest rates and exchange rates, etc. In order to analyze the possible effects of the Renminbi’s full convertibility on mainland China’s economy and to analyze the interaction between the Chinese economy and its foreign counterpart such as Hong Kong, we will develop an open macroeconomic general equilibrium model with micro foundations. Each economy in the model is assumed to be composed of a representative consumer and a firm.

28. The Behavior of a Representative Consumer

29. The Behavior of a Representative Firm

30. Solution:

31. Solution:

32. 4. The Impact of the Renminbi’s Full Convertibility on Mainland China’s Economy and Hong Kong’s EconomyA. The Impact on Mainland China’s Economy

33. A. The Impact on Mainland China’s Economy The process of the Renminbi’s full convertibility will have an extensive effect on mainland China’s economy. As suggested by the experience of most countries in the world, the most noticeable accompaniment of capital account liberalization will be the massive inflow of foreign investment.

34. A. The Impact on Mainland China’s Economy (continued)

35. A. The Impact on Mainland China’s Economy (continued) With respect to the effect of massive inflow of foreign investment, we can make an analysis from two angles, namely the effect on real economic activities and the effect on financial activities. We begin our analysis with the effect on real economic activities.

36. A. The Impact on Mainland China’s Economy (continued)

37. A. The Impact on Mainland China’s Economy (continued)

38. A. The Impact on Mainland China’s Economy (continued) In the above chain-reaction, the most important links are equation (42) and equation (34). The massive inflow of foreign investment will not necessarily increase the real productive capacity of capital and lead to an increase in domestic output. If the large-scale inflow of foreign investment is just in pursuit of profits in the securities market or real estate market, rather than ultimately entering the sphere of real production, bubble economy will result.

39. A. The Impact on Mainland China’s Economy (continued) As a consequence, certain preconditions, including (1) accelerating reform of domestic enterprises with the liberalization of capital account, (2) enhancing the efficiency of domestic enterprises in utilizing foreign investment, and (3) promoting the healthy development of domestic securities market so as to hold the bubble in check effectively, are needed for the conversion of massive inflow of foreign investment into real production capacity which will raise domestic output. Without these preconditions, massive inflow of foreign investment may cause some trouble.

40. A. The Impact on Mainland China’s Economy (continued) We will make an analysis of the effect from the other angle below, namely the effect on financial activities. Massive inflow of foreign investment will lead to an increase in domestic foreign exchange reserve, which will, under the fixed exchange rate regime, result in an increase in the corresponding issuance of the Renminbi. A large increase in domestic money supply will cause inflation and affect real exchange rate.

41. A. The Impact on Mainland China’s Economy (continued)

42. A. The Impact on Mainland China’s Economy (continued) The trend of rising imports and falling exports will cause China to run a current account trade deficit, which will cause a real devaluation of the Renminbi. A severe real devaluation of domestic currency may lead to the massive flight of foreign investment and even to the outbreak of financial crisis. Consequently, in the course of capital account liberalization, the Chinese government should adopt a more flexible exchange rate regime in order to avoid the occurrence of these problems. The whole chain-reaction discussed above is shown at Figure 1.

43. Figure 1 Effect of Massive Inflow of Foreign Investment

44. A. The Impact on Mainland China’s Economy (continued) In addition, in the course of capital account liberalization, there also exist some other issues, such as persistently deepening financial system reform, enhancing the competitiveness of domestic commercial banks, pursuing market-oriented interest rate, and strengthening financial supervision. Here in this paper, we do not intend to discuss these issues in detail.

45. B. The Impact on Hong Kong’s Economy The liberalization of China’s capital account and the full convertibility of Renminbi will undoubtedly have a far-reaching effect on Hong Kong’s economic development. The effect can be summarized as follows:

46. B. The Impact on Hong Kong’s Economy (continued)

47. B. The Impact on Hong Kong’s Economy (continued) (2) Portfolio investment aspect: When the mainland relaxes various restrictions on portfolio investment, there must be development in the listing of foreign-funded enterprises on the mainland stock market. In addition, more mainland residents could purchase stocks and other securities issued out of the territory. This will help Hong Kong’s firms getting listed in the mainland and enlarge the size of Hong Kong’s securities market.

48. B. The Impact on Hong Kong’s Economy (continued) Recently, that Hong Kong firms’ hope to get listed in the mainland has become a hot issue in Hong Kong. Chief executive of the Hong Kong Monetary Authority, Joseph Yam (2001),once stated his views about this issue on the web page of the Hong Kong Monetary Authority. He came up with some instructive proposals on how the mainland should gradually lift restrictions to enable Hong Kong’s firms to get listed in the mainland.

49. B. The Impact on Hong Kong’s Economy (continued) He (Joseph Yam) also put forward some quite meaningful opinions on how to outline the sequence of financial liberalization. He holds that, on one hand, rules designed to restrict the free flow or use of money are to be broken or to be circumvented so that further steps of liberalization should be taken. On the other hand, decision-makers should be careful about the pace of financial liberalization. Only when the attendant risks have been clearly identified and a prudent risk management mechanism has been put in place should the relevant steps, however beneficial, be taken.

50. B. The Impact on Hong Kong’s Economy (continued) (3) Imports and exports aspect: With the mainland’s accession to WTO and its continuous opening of capital account, the scale of imports and exports of the mainland will be further enlarged. This will offer Hong Kong more commercial opportunities. Thus Hong Kong’s role as a bridge in the field of trade will be enhanced.